A Beginner’s Guide to Liquidity Pools
Liquidity is the lifeblood of the financial world. Financial systems come to a halt when funds are not accessible. Decentralized finance, or DeFi, is a catch-all word for financial services and products on the blockchain.
Smart contracts—pieces of self-executing code—are used in DeFi activities, including lending, borrowing, and token exchanging. DeFi protocol users “lock” crypto-assets into these contracts, known as Liquidity Pools, so that others can use them.
What is a Liquidity Pool?
Liquidity pools are where pools of tokens are locked in smart contracts that provide liquidity in decentralized exchanges to mitigate the challenges posed by illiquidity in such systems.
Crypto liquidity pools are also the name given to the intersection of orders that result in price levels that, if reached, determine whether the asset will continue to move upwards or downtrend.
The automated market maker-based solutions are used by decentralized exchanges that leverage liquidity pools. The traditional order book is replaced on such trading platforms by pre-funded on-chain liquidity pools for both assets in the trading pair.
The benefit of using liquidity pools is that they eliminate the need for a buyer and a seller to agree to swap two assets for a defined price. Instead, they leverage a pre-funded liquidity pool. As long as there is a large enough liquidity available in the pool, trades can take place with minimal slippage, even for the most illiquid trading pairs.
Other users provide the funds that are locked in the liquidity pools, and they receive passive income on their deposits via trading fees based on the percentage of the liquidity pool that they provide.
Why Does Anyone Need A Liquidity Pool?
If you’ve ever traded on a traditional crypto exchange like Coinbase or Binance, you’ve probably seen that they use the order book model. This is how classic stock exchanges like the NYSE and Nasdaq operate.
Buyers and sellers meet in this order book model to place their orders. Buyers, often known as “bidders,” strive to get the best deal on an item, whereas sellers try to get the best deal on the same asset.
For exchanges to take place, both buyers and sellers must agree on a price. This might occur when a buyer raises their bid, or a vendor lowers their price.
But what if no one wants to place orders at a reasonable price? What if you don’t have enough coins to purchase? This is when the market makers enter the picture.
Market makers, in essence, are entities that make trading easier by constantly being available to purchase or sell a specific asset. As a result, they provide liquidity, allowing users to trade at any time without having to wait for another counterparty to appear.
So, why can’t we replicate something similar in decentralized finance?
Yes, we can do so!
It would simply be extremely slow, costly, and almost always result in a bad user experience.
The fundamental reason for this is that the order book approach is largely reliant on having a market maker or many market makers prepared to “create the market” in a given asset at all times. An exchange quickly becomes illiquid without market makers, making it almost unworkable for regular consumers. Furthermore, market makers frequently keep track of an asset’s current price by altering their pricing regularly, resulting in a large number of orders and order cancellations being submitted to an exchange.
Ethereum isn’t really a realistic alternative for an order book exchange, with a current throughput of roughly 12-15 transactions per second and a block time of 10-19 seconds.
Furthermore, every transaction with a smart contract incurs a gas fee, resulting in market makers becoming bankrupt simply by altering their orders.
So, how about scaling the second layer? Some 2nd layer scaling ideas, such as Loopring, appear promising, but they are still reliant on market makers and may run into liquidity concerns. Moreover, if a user wants to make one trade, he must move his funds in and out of the second layer, adding two more stages to the process.
This is why there was a need to design something fresh that could perform well in a decentralized environment, and this is where liquidity pools come in.
How Do Liquidity Pools Work?
Liquidity pools allow traders to buy or sell crypto quickly through a trading pair that would otherwise have little liquidity on a standard exchange. This is accomplished by using automated market makers, which enable crypto trading without the use of an order book.
Exchanges that use order book models might be classified as “peer-to-peer” exchanges, meaning that market participants trade with one another. AMMs that use liquidity pools as a source of liquidity are known as “peer-to-contract” exchanges. Instead of trading with another trader, market participants trade with a contract.
Automated market makers use liquidity pools to execute orders. As a result, a liquidity pool’s design must encourage liquidity suppliers to contribute or “stake” their assets in the pool. Most liquidity pools achieve this by rewarding participants for supplying liquidity. This usually takes the form of trading fees in exchange for their assistance.
Liquidity providers are frequently rewarded with liquidity provider tokens (LP tokens), which may be utilized in DeFi ecosystem applications. A liquidity provider who contributes to a liquidity pool is rewarded with a proportional quantity of LP tokens in exchange for their participation. The percentage of transaction fees a liquidity provider receives when trades are performed within the pool is then calculated using these figures.
How Much Liquidity Is Locked in DeFi?
In DeFi, liquidity is usually measured in terms of “total value locked,” which indicates how much crypto is entrusted into protocols.
According to the stats by DeFi Llama, the total TVL in DeFi was $110.81 billion as of April 2022.
TVL also aids in capturing DeFi’s rapid growth: Ethereum-based protocols had a TVL of only $1 billion in early 2020.
One of the main technologies in the current DeFi technology stack is liquidity pools. They allow for decentralized trade, lending, and yield production, among other things. Smart contracts currently fuel practically every aspect of DeFi and will most likely continue to do so in the future.